When fund management scandals have blown wide open over the years, time and time again the root cause has proven to be the same — a failure to confirm that the underlying assets are worth what the people managing them claim. That has been the case with Bernard Madoff, Allen Stanford and countless other con artists over the years.
One group that hasn't taken this lesson to heart is the managers of the nation's 80,000 private pension funds. With a reported $2.2 trillion in assets on hand, the majority do not subject their holdings to full audits. Some observers fear that the value of the pension plans' more opaque investments, including hedge funds and private equity, could be overstated.
The light oversight, formally known as limited-scope audits, has been a policy concern in Washington for years for years. The corporations that fund private pension plans have successfully lobbied Congress to keep limited-scope audits in place, arguing that full-blown audits of assets held by highly credible custodians would needlessly cost them millions of dollars in audit fees.
Pension regulators headed by the Department of Labor, in contrast, have pushed for years to put an end to limited-scope audits over fears that they open a door to bogus reporting.
Even back in the days of plain-vanilla pension portfolio, many observers considered limited scope audits a cause for concern. The Department of Labor has warned since the 1980s that relying on limited scope audits "seriously impairs the usefulness of the audit in protecting employee benefit plan assets." The DOL's inspector general and various accounting organizations have releases similar warnings. The exemption makes it impossible to tell whether unaudited investments are "vulnerable to mismanagement, fraud, or abuse," the Government Accountability Office and wrote in 1998.
Their concerns have increased recently along with the rise in holdings by pensions of relatively illiquid, hard-to-value alternative assets—a trend that may be reflected in trust banks' own efforts to distance themselves from valuation claims and the risks posed by the resulting legal fallout.
"The bank puts that [valuation] information into the trust record without independently verifying it," says Ian MacKay, director of Federal Affairs for the American Institute of Certified Public Accountants. "They're just passing along what they're told" by outside money managers.
In the event a pension fund fails to have an authoritative fair value for its holdings on hand, it is supposed to seek one from an independent source. Accepting a valuation at face value from a fund manager is never supposed to happen. However, industry insiders say it does.
"Some of my clients have all the right checks and balances in place," says Diane Walker, a partner at Johnson Lambert & Co., an accounting firm that audits pension plans. "With others you can tell someone promised them a certain return and they said, 'That sounds great!' and jumped right in." (In such instances, Walker says she helps the plan understand its responsibilities.)
But supporters of limited scope exams note that after decades on the books they are yet to result in known losses.
"We are not aware of a single incident in which a limited scope audit, per se, resulted in harm to a plan participant," David Wray, president of the Profit Sharing/401k Council of America, told the Labor Department's ERISA advisory council last year. "We also believe that repeal would greatly increase the cost of plan audits."
The growing stakes in the debate partly reflect how much has changed on the pension landscape since passage of the Employee Retirement Income Security Act (ERISA) in 1974. Back in the 1970s, pension assets were predominately held in easily valued stocks and bonds. As long as trust bank or insurers with custody of them verified their existence, the assets' value was considered a sure thing.
Over time, however, pension funds diversified into assets whose values were far less certain. In the six years through 2008 alone, the average S&P 500 corporate pension fund with alternative investments hiked its share from 7% to 17% of its portfolio holdings, according to the Center for Retirement Research at Boston College.
Such assets are often far less liquid and harder to value than widely held stock and bonds. What's more, the managers of the hedge funds and private equity partnerships who manage the assets are often paid based on the values they report, creating a conflict of interest in which it's to their financial benefit to make the numbers look as good as possible.
Major trust banks declined to discuss the limited-scope audits with American Banker. There are no indications that they face specific risks from them but they nevertheless appear to be moving to distance themselves from the reliability of the asset values they certify. They have done so in the past few years by altering the wording of their certifications to explicitly deny liability for false valuations.
"We typically only have one source [of valuation information], and that is the [asset] manager or fund's periodic statement," BNY Mellon managing director Kerry White told a Department of Labor committee last year. "We do not have a systemic way to verify the veracity of those prices ourselves."
Walker of Johnson Lambert believes the scrutiny given to fair valuation of assets has left the institutions nervous about their certifications, which even the banks concede carry little weight in regard to alternative assets.
"The wording used to be very standard," says Walker of certifications she used to run across during audits. "One I saw last year said that 'We are certifying the completeness and accuracy of these investments except for the fair value. From the point of view of an auditor, that is not very useful."
The possibility of erroneous or fraudulent valuations has worried the Department of Labor, the Government Accountability Office and accounting organizations for decades. But Congress has repeatedly blocked attempts to mandate independent audits or valuation of opaque investments.
"'Repeal of limited scope' is a phrase that just gets everybody up in arms on Capitol Hill," says Walker. The best that the Department of Labor could hope for, she says, "is to add guidance to specify when [pension funds] cannot use that option."
Another reason the limited scope controversy is heating up is a debate over the role of auditing in the failure of pension funds. In recent years, the plans of United Airlines, US Airways, and dozens of other companies have proven unable to pay the benefits they were meant to guarantee.
When a private pension fund fails, its assets are transferred to the Pension Benefit Guarantee Corp., a public insurance fund intended to protect pensioners. When it takes over a failed pension plan, the PBGC typically runs a "termination audit" to evaluate the value of the assets on hand. Notably, that does not include looking for discrepancies between actual results and what was claimed on a fund's previous financial statements.
Edward Siedle, president of Florida-based forensic accounting firm Benchmark Financial Services has investigated failed pension plans and believes virtually all of them received only a limited scope audit prior to their failure. He argues that greater scrutiny is needed.
"Forensic investigations I've undertaken involving failed multi-billion dollar plans indicate that this [the limited-scope audit] is a very real concern," says Siedle, who claims to know of specific instances in which limited scope audits caused harm to a plan's beneficiaries.
"No one is verifying the assets," he says. "That's a prescription for disaster… Any causal connection that exists between limited scope audits and plan failures really should be explored."
The PBGC told American Banker in a written statement that "While PBGC doesn't have authority to issue regulations on plan audits, we certainly have an interest in having companies accurately report their asset values. We support efforts to improve the accuracy and timeliness of plan information, in ways that do not overly burden pension plan sponsors."
